Why buy an instalment warrant instead of a share?

What are the advantages and disadvantages of buying an Instalment Warrant rather than just buying a share?

Response:

Instalment warrants are listed securities which trade on the ASX and each instalment warrant evidences a beneficial interest in an underlying security. Instalment warrants enable investors to acquire the underlying share by paying “instalments” over time. An amount is payable up front to acquire the warrant and a final optional instalment is payable if an investor wishes to acquire the underlying share. Therefore, instalment warrants enable investors and superannuation funds to increase their exposure to the stock market through leveraging.

Compared to directly investing in a share portfolio, investors are able to buy a greater quantity of instalment warrants using the same initial investment amounts. With increased exposure resulting from more units being bought, greater dividends and potential franking credits are achievable relative to purchasing the equal dollar value of the underlying shares outright. Additionally, if the price of the share or instalment warrant increases, you are able to achieve greater returns in percentage terms. However, it is important to note that negative percentage returns are also magnified if the share or instalment warrant price decreases.

Gearing is the feature of instalment warrants that enables investors to leverage investments and benefit for potentially greater returns and additional income. Generally, instalment warrants are geared at around 50-80%, meaning that the loan amount is more than half the price of the underlying share. This allows additional funds that would have been paid to purchase the underlying share to be invested in more units of the same instalment warrant, or diversified into different instalment warrants, securities or investments.

To illustrate the differences between a direct share investment and an instalment investment, let’s use an example:

In July 2007, Sam invested $10,000 in Australia and New Zealand Banking Group Ltd instalment warrants (ASX Code ANZIYH) through his self-managed super fund. His aim being to maximise his dividend income and exposure to the ANZ share price.

Assuming that ANZ pays a total of $1.48 per share in dividends and $0.63 per share in franking credits over the next year, here’s how Sam’s investment could compare to a direct shareholding*.

NB: Past performance is not an indicator of future performance

By investing in instalment warrants, Sam is able to gain exposure to 694 ANZ shares, meaning that with his initial capital outlay, dividend income and potential franking credits could be double that of a direct share investment. In addition, his instalment warrants could also enable him to claim an interest deduction, as he has effectively borrowed half the ANZ share price.

Whilst the results from the example above highlight the benefits of investing in instalment warrants, there are disadvantages to consider also.

1. Instalment warrants are a leveraged investment – Firstly, it’s also important for an investor to feel comfortable with borrowing to invest. Secondly in the event an underlying share price depreciates, negative percentage returns are magnified.

2. Voting rights – Instalment warrant holders do not have any voting rights in the event of a corporate action such as a takeover, merger, restructure, etc.

For more information

For further information on instalment warrants, visit the Australian Stock Exchange website. The ASX have a booklet titled “Understanding Trading and Investment Warrants” which is designed to give you a comprehensive understanding of the different types of warrants and how they work. A number of instalment warrant strategies are also available for download.

By Matt Comyn, General Manager, CommSec

Disclaimer:
The example is based on the IYH Series of instalment warrants, expiring on 14 May 2010. The example used should not be taken as a specific stock recommendation by Commonwealth Bank or CommSec. The purchase price of ANZ shares and the first and final instalment amounts for Commonwealth Bank Regular Instalment Warrants over ANZ shares are based on market prices as at 31 July 2007 and are indicative only. The dividends used are hypothetically assumed to be 100% franked and paid for the period 31 July 2007 to 31 July 2008, excluding special dividends. The assumed dividends are illustrative only and may bear no relation to any actual dividends paid on ANZ shares. Taxation information is based on the taxation laws and their application at 31 July 2007. Since individual circumstances differ, please seek your own independent taxation advice. Commonwealth Bank Regular Instalments IYH Series are issued by the Commonwealth Bank of Australia ABN 48 123 123 124 (Commonwealth Bank) and administered by Commonwealth Securities Limited ABN 60 067 254 399 (CommSec), a wholly-owned but non-guaranteed subsidiary of Commonwealth Bank and a Participant of the ASX. A Product Disclosure Statement for Commonwealth Bank Regular Instalments IYH Series is available and can be downloaded from commsec.com.au. The Product Disclosure Statement should be considered before making any decision whether to acquire, or continue to hold, the product.

This article was produced by CommSec. The information in this article is general in nature and does not take into account any investor’s particular objectives, financial situation or needs. In considering its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision. Except to the extent that any liability under any law cannot be excluded, no liability for any loss or damage which may be suffered by any person, directly or indirectly, through relying upon any information or statement in this document is accepted by the Commonwealth Bank or CommSec or any of their directors, employees or agents, whether that loss or damage is caused by any fault or negligence on their part or otherwise. Commonwealth Bank and its subsidiaries do not guarantee the obligations or performance of CommSec or the products or services offered.

Information contained in the brochure entitled “Understanding Trading and Investment Warrants” is produced by ASX Operations Pty Limited ABN 42 004 523 782 (‘ASX’) and intended for general information only. Neither ASX nor any related body corporate of ASX has had any involvement in the preparation of any part of this document, accepts responsibility for any statement herein, or has been involved in or consented to the issue of this document.